Morgan Stanley: Central Banks Are Playing a Game of Chess That Results in an Endless Cycle of Easing

The struggle for inflation is real and strategic

Checkmate, central banks.

Photographer: STEPHEN SHAVER/BLOOMBERG NEWS

After the European Central Bank decided to initiate an asset purchasing program, President Mario Draghi reportedly elected to unwind with a game of chess on his iPad during the plane ride back to Rome.

According to Morgan Stanley's Marco Spaltro and Jim Caron, Draghi's choice for a game could not have been more fitting. In a new commentary, the two portfolio managers argue that diverging monetary policies and persistently low levels of inflation mean that central banks are now engaged in a global game of chess.

Moreover, they say, this particular match won't end in a stalemate. Despite concerns that central banks have no moves left, the pair contends that all roads lead to competitive currency devaluations. 

Here's their extended analogy:

At the beginning of the game, the global economy is at an arbitrary point of equilibrium, similar to a chess board, with the pieces representing policy tools that are used to achieve one’s goal—growth and inflation—the king. Once a central bank makes an initial move to achieve a new equilibrium, it sets in motion a sequence of moves from other central banks, which we refer to as the opening repertoire. Suddenly, the game becomes unbalanced and requires more policy changes until a new equilibrium is achieved. …

In this game, central banks compete against each other by easing monetary policies in an attempt to meet their domestic, inflation-targeting mandates. Lack of coordination among central banks may mean that monetary policy remains lower for longer, leading to a semi-permanent low-yielding environment. At the end of the Global Chess Game, we are likely left with more central bank money, higher asset prices, low inflation and low yields.

MStanleyChess
Morgan Stanley

The punishment for trying to leave the game or refusing to play, according to the portfolio managers, is deflation.

While the portfolio managers make a comparison to chess, the scenario they depict also bears an even more striking resemblance to a game of hot potato, in which central bankers pass each other an unenviable deflationary parcel through their relative exchange rates.  

A central tenet of the portfolio managers' thesis is that ultralow interest rates have restrained inflationary pressures, since all that excess liquidity gave rise to overcapacity. Unconventional monetary policy measures, in turn, have only served to boost inflation to the extent that the domestic currency is weakened.

Under such a regime, bond yields will stay lower for longer, with yield curves flattening. The most attractive investment destinations, in terms of expected returns, will be locales in which central banks have sufficient room to boost stimulus and are heading in that direction, like Canada, New Zealand, and Australia, according to Spaltro and Caron. But in the realm of foreign exchange, those are the currencies the two recommend shorting while going long the U.S. dollar or British pound, since those central banks have expressed an intention to leave the chess game.

But even these opportunities will be fleeting, they warn, as both the Federal Reserve and the Bank of England will likely be forced to reverse course after importing deflation.

"In order to generate return in a world of low risk premia, timing reversals correctly will become a larger part of expected returns," they write. "As inflation converges quickly via adjustments in foreign exchange, central banks will likely change their stances to meet their domestic mandates."

In Spaltro and Caron's framework, all central banks are pawns—ultimately able to move in just one direction, by pressing down on the monetary accelerator. It's potentially an incredibly pessimistic scenario.

However, there is some hope.

paper presented at the Jackson Hole Economic Symposium suggests that the world's most powerful central bank might be able to act like a king and break this presumed chain of competitive devaluations. 

Gita Gopinath, professor at Harvard University, found that when it comes to the effect a rising currency has on inflation, the buck stops with the Fed.

Because a high portion of global trade is invoiced in U.S. dollars and these prices tend to be sticky, "U.S. inflation is consequently more insulated from exchange rate shocks, while other countries are highly sensitive to it," she concluded.

As such, Morgan Stanley's chess analogy could be put to the test in short order, as it just so happens that the one country with the most immunity to importing deflation is the one on the verge of embarking upon a tightening cycle.

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